Business Environment and Concepts

PROBLEMS AND SOLUTIONS RISK MANAGEMENT

1. Investors are generally considered to be risk neutral. (True or False?)
Answer-A risk neutral investor is indifferent to levels of risk. Most financial theories
consider investors to be risk averse, which means that investors will accept higher
levels of risk but they must be compensated in terms of increased returns. (False)
2. A firm has a portfolio with the following three assets and expected returns:
Asset 1 $2,000,000 6%
Asset 2 $2,000,000 9%
Asset 3 $4,000,000 12%
The expected return of the portfolio is equal to 9%. (True or False?)
Answer ~ The expected return of a portfolio is calculated as the weighted-average of
the expected returns of the individual assets making up the portfolio. In this case, the
expected return is 9.75% ((6% x 2/8) + (9% x 2/8) + (12% x 4/8)). (False)
3. A balanced portfolio can be used to diversify away unsystematic risk. (True
or False?)
Answer - Unsystematic risk is the risk of an individual investment or a group of
related investments. Systematic risk is the risk of the market as a whole. A balanced
portfolio can diversify away unsystematic risk but it cannoi diversify away systematic
risk. (True)
4. The unsystematic risk of a particular investment is measured by the
investment's beta. (True or False.)
Answer - Beta is calculated as the covariance of a particular investment's return with
the return of the overall portfolio divided by the variance of the portfolio. Therefore,
it measures the systematic risk of the investment not the unsystematic risk. (False)
5. The risk that a bond will decline in value due to an increase in interest rates
is referred to as market risk. (True or False?)
t Answer - Market risk is the risk of loss on a loan or bond due to a decline in the
aggregate value of all assets. Interest rate risk is the risk of loss on a loan or bond
due to an increase in interest rates. (False)
6. Liquidity preference theory would predict the yield curve to be normal. (True or
False?)
Answer - Liquidity preference theory states that investors must be paid a premium for
less liquid (longer term) investments. Accordingly, the theory would predict short-
term rates to be lower than intermediate-term rates which would be lower than long-
term rates. This describes the normal yield curve. (True)
7. To hedge an increase in short-term interest rates, a firm may use the strategy
of selling Treasury bills on the futures market. (True or False?)
Answer - Selling Treasury bills on the futures market locks in the current short-term
rate. Accordingly, this is an effective strategy for hedging increases in short-term
rates. (True)

36 - Risk Management